Prepared by BAD BEAT Investing senior analyst Tara
The Greenbrier Companies (GBX) is a stock we have traded several times in the last year plus. As you know, the stock has been volatile in recent months, but, of course, took it on the chin in March and April with global markets. Shares recovered somewhat in the spring and had recently begun to fade along with so-called “reopening” names that depend on strong industrial activity. As you may also recall, we had moved to a heavy cash position when news of the virus in the U.S. broke, and within the last two weeks we started to redeploy. We added heavily into GBX in our long-term portfolio in early April. It is our opinion that while the near-term is still tough to handicap, it is time to start buying names that will do well when the economy opens back up. But you have to be selective, and scale in as the market allows. Demand will not return overnight. While transports have been crushed, this is a sector that stands to do very well. We think this stock is a buy. The most recent quarter showed key strengths and several ongoing weaknesses to be aware of.
Most recent quarter
Based on the stock’s reaction to the just reported quarter, Q3 was very well received. Much like in the last two quarters, Greenbrier’s efforts to transition to a more efficiently run operation to drive performance are starting to materialize. Based on headline results, it may appear that these transition efforts were not reflected in the results. While it is true that there remains work to be done to reduce merger integration expenses and boost operational efficiency, with the global economy slowing thanks to COVID-19, pressure was felt. Event at this juncture in the crisis, the outlook is somewhat cloudy. Still, there remains positive momentum in the COVID-19 death rate and weekly news on progress with vaccines. That is good for reopening. We expect the stock to do well over the next 12-18 months.
Make no mistake, the next quarter or so will still be tough and that is why the guidance is still absent. Beyond layoffs and other obvious reductions, we see the company taking aggressive actions to shrink its cost profile and to improve its balance sheet. Keep an eye on commodity demand and industrial output as these are often associated with higher rail data. Let us discuss the metrics we will look for going forward using Q3 results as a guide.
Revenues fell again
When we look to the sales figures, we noted Q3 revenues fell once again, though far less than expected. The revenues were $100 million above our expectations. We expected revenues to fall much more heavily. Our expectations were based on the trends in Q2 carrying over to Q3. A lot of pressure did continue on existing orders and anticipated deliveries. However, it was better than expected. Revenues will continue to deteriorate in the next quarter or so.
Revenues came in down 10.9% year-over-year to $763 million. We were a bit surprised by the miss but not as much when we consider the market action leading into March and into the earnings report. We do note that consensus was surpassed by $150 million. We were more bullish than the Street on reopening hopes, but still expected far less revenue. Let us dig deeper.
We see some strengths that emerged in the quarter as well as some notable weaknesses. The company is still doing all it can to strengthen its core North American market, continuing international diversification, and growing the business.
The top line was well above expectations, but there was strength in some lines. The company has been working hard to complete the integration of its massive acquisition in North America. With the work being put in, the synergies Greenbrier expected from acquiring the ARI manufacturing assets have begun to be recognized. We are seeing Greenbrier’s international expansion contributing to each quarterly result and is helping make up for a weak North American freight railcar market, but make no mistake, the virus is impacting things obviously beyond the States. That said, this is temporary.
International markets are providing the company with new sources of revenue and a diversification of the backlog. Order activity was decent in the quarter and comprised of a broad range of railcar types. The company is entering its Q4 with relatively decent railcar order activity. As for some actual data, deliveries were 5,900, while in the quarter, just 800 orders for new rail cars were received, and this impacted the backlog, which is still strong. Orders originating from international sources accounted for over 50% of the activity of the quarter and this mix did impact the average sales price of order activity.
The backlog remains strong
The backlog remains a key indicator to keep an eye on. We continue to believe that the Street has some concerns here. We think the market is valuing the company lower because it expects a prolonged period of low volumes for orders and deliveries, despite a big backlog. The market is now pricing in continued pressure on orders because of a sizable backlog, in conjunction with rail shipping data (subscription may be required), with fear of big declines in future orders. While we saw above that massive international order, those concerns persist. In this case, backlog increased.
While the company delivered 5,900 railcars, order volume, which can be tough to predict, was 800 in the quarter as we noted. Demand will not return overnight, but there is a solid backlog. The backlog is a key indicator and reflects future cash flow generation and earnings. With Q2 2020 activity, we saw an expansion to 30,800 units. Here in Q3, with lower order volume, new railcar backlog was 26,700 units with an estimated value of $2.7 billion. Looking ahead, you must watch for trends in new orders. What about profitability?
Margins widened helping earnings
Gross margin erosion had been an issue in recent quarters, but recently began expanding thanks to cost savings initiatives. Gross margin increased to 14.1% from 13.8% in the sequential quarter. It is also up from 12.0% in Q1. There has been an improved product mix and pricing control that has offset operational inefficiencies due to production delays as well as minimal syndication activity. Let us look at the segments in Q3.
There was nice improvement in the manufacturing segment versus the sequential Q2. Gross margin was 13.8% in the manufacturing segment which matched Q2. We are still well above the lows of 6.9% in Q2 2019. Operating margin improved to 10.5% from 9.4%. There were higher deliveries here and increased syndication activity. For a few years, the wheels, repairs, and parts segment has been burdened with high costs, but saw an 8.57% margin, up from 7.5% last quarter. Operating margin also improved here to 4.6% from 3.6%. This was the third quarter in a row of strength for the segment profitability wise, although there were lower volumes in wheels and wheelset parts. Finally, leasing and services saw margins rise from 27.8% to 37.4%, because Q2 had a lot of syndication volumes which are lower margin. All in all, this was better than expected. Further, all of this is what you need to watch going forward. It all led to EPS beating our expectations by $0.70 and consensus by $0.91. The EPS came in at $1,05, up nicely from $0.46 last year.
The third quarter was better than expected as a whole. The COVID-19 slowdown in orders and activity is temporary. While order volume was low this quarter, the backlog is solid for quarters to come. We expect improvement into 2021. We think you should be long here for future share appreciation. Consider following us into this long-term play.
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Disclosure: I am/we are long GBX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.